Day-6 Cash Flows

Learning Objectives
3.1 Compute a company’s profits, as reflected by its income

statement.
3.2 Determine a firm’s financial position at a point in time
based on its balance sheet.
3.3 Measure a company’s cash flows.
3.4 Describe the limitations of financial statements.
3.5 Calculate a firm’s free cash flows and financing cash
flows.
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The Income Statement
The Income Statement
• It is also known as profit/loss statement.
• It measures the results of firm’s operation over a specific
period.
• The bottom line of the income statement shows the firm’s
profit or loss for a period.
Sales − Expenses = Profits
Income Statement Terms (1 of 2)
• Revenue (Sales)
– Money derived from selling the company’s product or
service
• Cost of Goods Sold (COGS)
– The cost of producing or acquiring the goods or
services to be sold
• Operating Expenses
– Expenses related to marketing and distributing the
product or service, general administrative expenses
and depreciation expense
Income Statement Terms (2 of 2)
• Financing Costs
– The interest paid to creditors
• Tax Expenses
– Amount of taxes owed, based upon taxable income
Figure 3.1 The Income Statement: An
Overview
Common-Sized Income Statement
• Common-sized income statement restates the income
statement items as a percentage of sales.
• Common-sized income statement makes it easier to
compare trends over time and across firms in the industry.
• See Table 3.1.
Table 3.1 Walmart: Income Statement for the year ending
January 31, 2018 (expressed in millions, except per
share data, and as a percentage of sales)
Profit-to-Sales Analysis from
Common-Sized Income Statement
• See Table 3.1
– Gross profit margin (or percentage of sales going
toward gross profit) is 25.4%.
– Operating profit margin (or percentage of sales
going toward operating profit) is 4.1%.
– Net profit margin (or percentage of sales going
toward net profit) is 2.0%.
The Balance Sheet
The Balance Sheet
• The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
• It includes three main items: assets, liabilities, and owner-
supplied capital (shareholders’ equity).
– Assets (A) are resources owned by the firm.
– Liabilities (L) and owner’s equity (E) indicate how
those resources are financed:
A=L+E
• The transactions in balance sheet are recorded at cost

price, so the book value of a firm may be very different
from its current market value.
Figure 3.2 The Balance Sheet: An
Overview
Balance Sheet Terms: Assets (1 of 2)
• Current assets comprise assets that are relatively liquid,
or expected to be converted into cash within 12 months.
Current assets typically include:
– Cash
– Accounts receivable (payments due from customers
who buy on credit)
– Inventory (raw materials, work in process, and finished
goods held for eventual sale)
– Other assets (e.g., prepaid expenses are items paid
for in advance)
Balance Sheet Terms: Assets (2 of 2)
Long-Term Asset
• Fixed Assets
– Include assets that will be used for more than one year.
Fixed assets typically include:
 Machinery and equipment, buildings, land
• Other Assets
– Assets that are neither current assets nor fixed assets.
They may include long-term investments and intangible
assets such as patents, copyrights, and goodwill.
Balance Sheet Terms: Liabilities
(1 of 2)
• Debt (Liabilities)
– Money that has been borrowed from a creditor and
must be repaid at some predetermined date.
– Debt could be current (must be repaid within 12
months) or long-term (repayment time exceeds one
year).
Balance Sheet Terms: Liabilities
(2 of 2)
• Short-Term Debt (Current Liabilities)

– Accounts payable (Credit extended by suppliers to a
firm when it purchases inventories)
– Accrued expenses (Short-term liabilities incurred in
the firm’s operations but not yet paid for)
– Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)
• Long-Term Debt
– Borrowings from banks and other sources for more
than one year
Balance Sheet Terms: Equity
• Equity: Shareholder’s investment in the firm in the form of
preferred stock and common stock. Preferred stockholders
enjoy preference with regard to payment of dividend and
seniority at settlement of bankruptcy claims.
• Treasury Stock: Stock that have been repurchased by
the company
• Retained Earnings: Cumulative total of all the net income
over the life of the firm, less common stock dividends that
have been paid out over the years
– Note that retained earnings are not equal to hard cash!
Balance Sheet: A = L + E
• Assets (A) • Liabilities (L)
– Current Assets – Current Liabilities
– Fixed Assets – Long-Term Liabilities
 Total Assets  Total Liabilities
• Owner’s Equity (E)
– Preferred Stock
– Common Stock
– Retained Earnings
 Total Owner’s Equity
 Total Liabilities + Equity
Table 3.2 Walmart Balance Sheet for Years Ending
January 31, 2017 and January 31, 2018 (expressed in
millions) (1 of 2)
Table 3.2 Walmart Balance Sheet for Years Ending
January 31, 2017 and January 31, 2018 (expressed in $
millions) (2 of 2)
• Total assets exceeded $200 billion, consisting of about

one-third current assets and two-thirds of long-term assets
• Holding over $6 billion in cash, or about 3% of all the
company’s assets.
• Held 21 percent of its assets as inventory and 3% as
accounts receivable.
• Property, plant and equipment accounted for about 56% of
its assets.
• Intangible assets made up 15% of the assets.
Debt Ratio
• Debt ratio is the percentage of assets that are financed by
debt.
• Debt ratio is an indication of “financial risk.” Generally, the
higher the ratio, the more risky the firm is, as firms have to
pay interest on debt regardless of the earnings or cash
flow situation.
Net Working Capital
• Net Working Capital = Current assets − current liabilities
– The larger the net working capital, the better the firm’s
ability to repay its debt.
– Net working capital can be positive or zero or negative.
It is generally positive.
– An increase in net working capital may not always be
good news. For example, if the level of inventory goes
up, current assets will increase, and thus net working
capital will also increase. However, increasing
inventory level may well be a sign of inability to sell.
Measuring Cash Flows
Measuring Cash Flows
• Profits in the financial statements are calculated on
“accrual basis” rather than “cash basis.”
• Thus, profits are not equal to cash.
Accrual Basis Accounting
• Accrual basis is the principle of recording revenues when
earned and expenses when incurred rather than when
cash is received or paid.
– Thus, sales revenue recorded in the income statement
includes both cash and credit sales. Similarly,
inventory purchases may not be entirely paid for in
cash because suppliers may extend credit for some of
the purchases.
• Treatment of long-term assets: Asset acquisitions (that
will last more than one year, such as equipment) are not
recorded as an expense but are written off every year as
depreciation expense.
The Beginning Point: Changes in the
Balance Sheet and Cash Flows
Table 3.3 Walmart’s Changes in
Balance Sheets Between 2017 and
2018 Create Sources and Uses of
Cash ($ millions)
Figure 3.3 Statement of Cash Flows:
An Overview
Three Sources of Cash Flows (1 of 2)
• Cash flows from Operations (e.g., sales revenue, labor
expenses)
• Cash flows from Investments (e.g., purchase of new
equipment)
• Cash flows from Financing (e.g., borrowing funds,
payment of dividends)
Three Sources of Cash Flows (2 of 2)
• If we know the cash flows from operations, investments,
and financing, we can understand the firm’s cash flow
position better, that is, how cash was generated and how it
was used.
Income Statement Conversion: From
Accrual to Cash Basis
• Cash Flow from Operations: Five Steps
1. Add back depreciation.
2. Subtract (add) any increase (decrease) in accounts
receivable.
3. Subtract (add) any increase (decrease) in inventory.
4. Subtract (add) any increase (decrease) in other current
assets.
5. Add (subtract) any increase (decrease) in accounts
payable
6. Add (subtract) any increase (decrease) in other
accrued expenses.
Figure 3.4 Cash Flow from Operations
Walmart’s Cash Flow from
Operations
Cash Flow from Investing in
Long-Term Assets
• Long-term assets include fixed assets and other long-term
assets. A firm may be engaged in acquisition and sale of
such assets leading to cash flows.
• Walmart example:
Cash Flows from Financing the
Business
Financing the Business Illustrated:
Walmart
Table 3.4 The Walmart Company Statement of Cash
Flows ($ millions) Year Ended January 31, 2018
Suggestions for Computing Cash
Flows
• Consider one section at a time.
• You need only two items from the income statement: net
income and depreciation expense.
• Consider change for all items in the balance sheet, except
ignore accumulated depreciation and net fixed assets;
ignore change in retained earnings.
The Limitations of Financial
Statements and Accounting
Malpractice
Accounting Malpractice and
Limitations of Financial Statements
• Financial statements are prepared following the Financial
Accounting Standards Board’s generally accepted
accounting principles (GAAP).
• Because accounting rules give managers discretionary
powers, it is possible that two firms with similar financial
performance may report different results.
• There have been several cases of accounting malpractice
where rules have been broken.
Key Terms (1 of 7)
• Accounts payable (trade credit)
• Accounts receivable
• Accrual basis accounting
• Accrued expenses
• Accumulated depreciation
• Balance sheet
• Book value
• Cash
Key Terms (2 of 7)
• Cash basis accounting
• Common-size balance sheet
• Common-size income statement
• Common stock
• Common stockholders
• Cost of goods sold
• Current assets (gross working capital)
• Debt
Key Terms (3 of 7)
• Debt ratio
• Depreciation expense
• Dividends per share
• Earnings before taxes (taxable income)
• Earnings per share
• Equity
• Financing cash flows
• Fixed assets
Key Terms (4 of 7)
• Fixed costs
• Free cash flows
• Gross fixed assets
• Gross profit
• Gross profit margin
• Income statement (profit and loss statement)
• Inventories
• Liquidity
Key Terms (5 of 7)
• Long-term debt
• Mortgage
• Net fixed assets
• Net income (net profit, or earnings available to common
stockholders)
• Net profit margin
• Net working capital
• Operating expenses
Key Terms (6 of 7)
• Operating income (earnings before interest and taxes)
• Operating profit margin
• Other current assets
• Paid-in capital
• Par value
• Preferred stockholders
• Profit margins
• Retained earnings
Key Terms (7 of 7)
• Semi-variable costs
• Short-term debt (current liabilities)
• Short-term notes (debt)
• Statement of cash flows
• Treasury stock
• Variable costs

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Learning Objectives

3.1 Compute a company’s profits, as reflected by its income

Sales − Expenses = Profits

• The transactions in balance sheet are recorded at cost

• Short-Term Debt (Current Liabilities)

• Total assets exceeded $200 billion, consisting of about

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